Why the EU should think twice before granting a loan to Greece

The disaster everyone feared for several months finally occurred yesterday – Greece’s credit rating was reduced to junk status and financial markets slumped. Moreover, Portugal’s debt has also been downgraded, Spanish stocks plunged more than four percentage points and in Italy it was difficult to sell government bonds.

The outgoing vice-president of the European Central Bank, Greece’s Lucas Papademos, told lawmakers at the European Parliament that other European countries have "similar problems", although "not to the same degree" (AFP). Still, the most urgent situation is clearly that of Greece.

Creditors are asking for exorbitant interest (over 9%) for holding Greek bonds and the government has to find money before the 19 of May when Greece hits a key debt deadline. The EU partners have therefore to decide quickly whether or not they want to help Greece to deal with the crisis.

The decision is a difficult one. On one hand, a rescue policy would have important consequences in terms of incentives. To rescue Greece is to send a signal to other governments that says “go ahead, spend more than you have, we will cover your back”. And this signal would be sent at a time where several EU countries are in a tangent situation. Spain, Ireland, Italy, Belgium and even France had catastrophic public finances balance in 2009, with a public debt well above the level imposed by euro zone’s rules . On the other hand, there are fears that problems with Greece could easily lead to cracks in the euro system, which will necessarily have an impact on every euro zone country.

The situation looks similar to the situation of the banking sector last year – we don’t necessarily approve what they did, but we have to save them, because otherwise their crash will hurt us too. Systemic risk, as they say! But it is not exactly the same. For one thing, it is far from certain that the EU-IMF loan will be enough to save Greece from bankruptcy. It will surely help them to face the May deadline but Greece has still to find four or five times that amount in the coming year. Also, it is clear that the EU could relatively easily overcome a bankruptcy of Geek public finance; while a bankruptcy of Portugal, Spain or Italy would be a fatal blow to the EU and the Euro.

As always, a wise decision requires that we look not only at immediate consequences but try to look further down the road. May 19th is not the end of the story.